The Journal of Index Investing recently featured a paper on evaluating defensive equity strategies. Okay, it’s our paper. We’re flattered, of course, but what’s more important is the timing of their feature, given the number of record highs we’ve seen in equity markets this year.
Why Defense Matters
If your actuarial targets continue to necessitate significant equity exposure, then the Journal’s article is definitely worth your time. Defensive equity strategies offer you a way to maintain – even increase – equity exposure without the corresponding increase in risk. They seek market-like returns, lower volatility, and greater downside protection across a full market cycle. Selecting the right active manager potentially adds even more value.
These are essential attributes in volatile markets because if your equities are a liquidity source for your plan, withdrawing capital in down-markets to pay benefits can have devastating consequences on your funded status. It leaves less capital for future growth.
To demonstrate the cumulative impact of this threat, we only have to look at the first decade of the millennium. We aren’t that far removed from the bursting of a stock market bubble led by tech names with wildly inflated valuations (sound familiar?) and a subprime mortgage crisis virtually no one saw coming. Bookended by two massive drawdowns in U.S. and global equities, that decade represented a worst-case scenario for plans relying on equities to meet return targets. From 2000-2009, the annualized returns (in USD) of the MSCI USA and MSCI World Index were -1.29% and 0.23%, respectively.
Using hypothetical equity portfolios, you can see the impact of capital withdrawals during that period (below). We show a typical scenario in which a plan with a $100 million equity allocation must withdraw 4% annually, increasing with inflation. A plan relying exclusively on passive exposure to a cap-weighted index would have had its market value cut by over 50%. On the other hand, a passive allocation to a Minimum Volatility Index would have lost considerably less, preserving an additional $33 and $40 million for U.S. and global portfolios, respectively.
Selecting Your Defensive Line-up Isn't Easy
If the growing assets and variety of defensive equity offerings are any indication, the strategic benefits of adding defensive equity to your equity allocation lineup are becoming more and more accepted. It makes practical sense: who wouldn’t want to improve the resiliency of an equity exposure tasked with a greater share of the burden of capital appreciation? Many institutional and individual investors appear to have made this work very well within their equity lineups.
For others, however, it can be tactically awkward. The high tracking error typically associated with defensive positioning that can deviate greatly from the market for long periods can be unpalatable for investment professionals, committees, boards, and even 401(k) participants used to processing manager skill through the lens of relative risk-adjusted returns. They may have a difficult time assessing efficacy in long up-market periods, when typically lagging defensive strategies create poor optics and create behavioral stresses, even when the strategies work as intended.
Change Your Benchmark, Ease Your Evaluation
The Intech paper spotlighted in the Journal of Index Investing offers a way to alleviate this concern: substitute or supplement a defensive equity index for the usual cap-weighted benchmark. And given the constraints of Minimum Volatility Indexes, we believe that active management can improve their value proposition – while maintaining their defensive benefits. Get complimentary access to the article for a limited time.
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